It seems like everyone has a cousin who knows a guy that used a “secret” loophole to avoid paying a bunch of tax. I always say the same thing when someone brings that up: “Oh really? Well, then, you should probably go hire that guy!”
I hate it when professionals try to pull the wool over the eyes of clients by making them think these things are super secret or complicated or a fancy loophole. I like simple; it’s kind of my thing. Oftentimes, the application or implementation of some of these ideas can be complex, but the theories behind them are very straightforward. Understanding the theories can help you discuss and decide intelligently. So, here is my Business is Simple guide to avoiding tax on business sales or other large asset sales.
The first part of this theory is to understand the underlying law or principle. That law is this:
As you increase the amount of tax deferred, you also increase the amount of control you have to give up to do it.
That is the trade off. It cannot be avoided. The tax code is designed to prevent you from having your cake and eating it, too. It is true for every loophole and trick you have ever heard of. That being said, the methods you can use, in order of usefulness, are Reduce, Defer, and Eliminate.
There are two things you can reduce: Gain or Rate. Reducing the gain means, obviously, you reduce the amount you stand to earn from the sale. Reducing the rate means that you pay a lower tax rate. For example, if you have a capital gain instead of ordinary income you would pay a lower tax rate. Reduction is not something that you can do easily. Usually everything that would qualify as a reduction has already been taken into account. The type of sale is usually set ahead of time. That is why reduction is kind of the low hanging fruit. If you can find something that was forgotten, great! And since it has the lowest chance of changing anything, reduction strategies usually do not require very much loss of control.
Your gain is what you are paying tax on. It is what you are selling the thing for minus what you paid for it (basis). So, the first step is to see how we reduce the gain. We can reduce it by reducing the sale price. Probably not a good tactic. Which means you have to increase your basis. Did you put money into the business or into the property at some point? Did you have losses on the business or property in the past you didn’t deduct? These increase your basis. Did you inherit the property or business? Did the property get a step up when you did? A “step up in basis” is what happens when you inherit something. Your basis becomes the fair market value on the date of death. None of these things apply? Next item.
This applies mostly to business sales. Businesses have two types of sales, asset and stock. In an asset sale a business sells the assets of the business (you would still own the entity you had beforehand, but as an empty shell). In a stock sale, you sell the shares of the corporation that owns the business assets. Why do we care? If you sell the assets, most of the gain you have will be ordinary income with tax rates up to 39.6%. If you sell the shares you have a capital gain where tax rates are only around 20%. That is a great trick. But most buyers of businesses want to buy assets, not shares. So, negotiate. If you do have an asset sale, you get to allocate the purchase price amongst the assets you are selling. So, you want to sell the hard assets (machinery, autos, equipment) for as high as you can (these are capital gain) and you want the non-compete or goodwill (ordinary income rates) to be as low as possible. Don’t screw the deal over this, but understand this can have a huge impact.
That concludes Part One of the guide. Look for Part Two where we discuss strategies to Defer taxes.
If these strategies are interesting, or you think you might need additional help, please go to the contact page. I would love to work with you!
Big shout out to Jason Rehmus and http://sweatingcommas.com/ for all his help in making this readable. I would be unintelligible if he wasn’t around.